S corporation or LLC: when it makes sense to switch

The question usually comes up when the business starts to make a good profit: should it become an S corporation? The answer depends on the numbers.

Where the savings come from

In a single-member LLC, all profit is subject to the 15.3% self-employment tax, up to the Social Security wage base. In an S corporation, an owner who works in the business takes a reasonable salary through payroll, and the remaining profit is distributed without that tax. The difference is the savings.

What it costs

An S corporation requires payroll with quarterly filings, its own return, Form 1120-S, and orderly books. If profit is low, those costs can exceed the savings. The salary must also be reasonable for the owner's work; setting it artificially low is a risk with the IRS.

Who cannot elect it

An S corporation can have up to 100 shareholders, all individuals who are U.S. citizens or residents, with a single class of stock. A nonresident alien partner prevents the election. In that case other structures must be considered.

How and when to elect

With Form 2553, within two months and fifteen days after the start of the year in which it should apply. If filed late, the IRS often allows a correction with an explanation of the cause.

Before deciding

Run the projection with the business's actual numbers. When the decision involves the group's overall structure or new partners, we work on it together with Padilla Advisory Group.